Shah Gilani writes:
Speculation is running rampant about what really happened to the markets last week.

In case you missed it, as Fed Chairman Ben Bernanke was chatting up Congressional clowns last Wednesday morning, Treasury bond prices collapsed in one minute flat, and gold dropped 3.73% in less than an hour, ending $90 an ounce (or 6%) lower.

Was it a "ghost in the machine" flash crash?

Was it a "fat finger" error?

What happened?

Starting at 10:40 a.m. on Wednesday morning, sell orders began cascading into the 10-year Treasury bond pit at the Chicago Merc. The heaviest selling occurred between 10:43 and 10:44, but continued until 10:54.

A massive 80,000 contracts for June delivery were dumped in the pit, followed by another 47,000 contracts. While another 52,000 contracts of five-year note futures were simultaneously dumped.

The price action was so heavy, the 10-year yield rose from 1.94% to 2.01% in a flash.

Over at the gold pit, some 31 tons of gold was sold, rather quickly.

Turns out, it wasn't a fat finger. You know, a fat finger - when someone accidentally types a mistake into a trading computer. Like, maybe they were supposed to type in a sell order for 8,000 contracts, and they hit the zero key one time too many, and they sell 80,000 contracts.

Well, according the Merc, it wasn't a fat finger error. They were all proper trades.

So if it wasn't a fat finger, was it a flash crash caused by some computer programs doing their algo thing and unloading both barrels?

No, that's not likely, either.

The truth is, we still don't know exactly why it happened.

But I'm going to tell you what I think it was...

The Maiden Lane Warning

The usually dour bearded Ben wasn't his usual doom-and-gloom self. In fact, that morning he was pooh-poohing the idea that a new round of quantitative easing - or QE3, or 4, or 5, or whatever it really is - was on the Fed's front burner at this juncture of better-than-expected economic numbers coming from left and right.

Of course, we're not out of the woods, especially on the housing front. But the immediate reaction to taking QE3 off the table likely resulted in the dumping of bonds.

Because the Fed has been excessively accommodative, especially buying mortgage paper to support that market, hedge funds and huge institutions have been bullish on bonds and especially mortgage paper.

The Fed recently sold the last of its Maiden Lane inventory. (That's the name of a street in lower Manhattan where the Fed has some office space and was housing billions of dollars of mortgage bonds that it kindly took off the hands of AIG (NYSE: AIG) and some other miscreants who couldn't stay above water.)

Who bought the poisoned paper? Big banks, of course. Mostly, they said, for customers. That means hedge funds and institutions betting that the Fed was eventually going to fix the mortgage markets, and prices would rise nicely.

But hedge funds who have been loading up on mortgage paper use a lot of leverage. Some as much as 30 times their capital, and some even more.

What does that have to do with the price of rice in China, you ask?

Try this on for size.

Once Big Ben put QE3 out of immediate reach, the implication is that mortgage paper may not get the backstop it has been given by the Fed.

Maybe once they dumped their own Maiden Lane inventory, they decided, let the buyers beware.

Back to the price of rice. Make that gold.

If the Fed isn't going to keep flooding banks with cash, and keep their printing presses running 24/7, then maybe we won't have the great inflation that some speculators are betting on.

Maybe there's no need to hedge that scary future by holding gold.

That's one thing that could have triggered the gold sell-off immediately after the T-bond sell-off.

But there's another reason the gold sell-off could have occurred. If leveraged hedge funds don't see the mortgage market that they've bet heavily on running higher, maybe they began dumping gold to raise cash to offset falling mortgage prices.

And guess what? As T-bond prices were collapsing, so were mortgage bonds.

Mortgage bonds are a lot less liquid than gold, which a lot of funds have been holding and profiting from.

Why Caution is Prudent (for Now)

We'll see this week if there's more selling of liquid assets, as some of these funds are going to get margin calls - as are a lot of gold buyers who piled onto the gold trade late in its recent rise and just before last week's fall from grace.

If we're nearing the top of the recent rallies everywhere, which is possible, partly now because Ben has taken QE3 off the table, for now, I want to be more cautious.

We're still trying to make a run at important benchmark levels, and I think we've got a better than 50/50 chance of breaking through on all of them. But I am beginning to worry.

If gold breaks its support at 1689 and then breaks through 1540 (its major support) on margin selling pressure, I'm going to get very, very, bearish.

Also last week, the Russell 2000 broke down. That's not good news at all. It means that the headline indexes are all puffed up because of media hype and one very shiny Apple Inc. (Nasdaq: AAPL). But underneath, the broader market of less-hyped stocks is rolling over.

It's time to buy the VIX. Don't hesitate; it's near its February 3, 2012, lows, and so what if it goes lower? We're getting close to where we were last year before the markets rolled over. So, in case they do, I want to start putting on some protection.

I also said oil was worth the risk, and I still think it is worth buying. On that one, I'll be watching the $101.56 WTI price level as support, and if oil breaks $99, I'm out with a small, less than 10% loss.

We've had a good run, and I hope it continues. But when I see things here and there breaking down or cracking, I start to think about a correction and how to position myself.

You should too.

Editor's Note: If you're fed up with the rampant corruption, double-dealing, and protection of Wall Street by Washington (at the expense of the taxpayers on America's Main Street), then you need to read Shah Gilani's Wall Street Insights & Indictments newsletter.

As a retired hedge-fund manager, Gilani is a former Wall Street insider who knows where all the bodies are buried. But unlike most insiders, he's not afraid to tell you where they are.

He's also got some pretty good ideas how to fix this mess - and how to protect yourself until the cleanup takes place. Please click here to find out more about Shah's free newsletter.

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